Tuesday, February 5, 2013

John Cochrane on New Keynesian Models

John Cochrane wrote a wonderful post on thinking his way through New Keynesian models.  Its quite wonkish, but it is great insight into how a top economist thinks about the world and models.  Also, I thought Karl Smith gave a thoughtful rebuttal.

Feel free to get deep in the weeds of both posts, but essentially John lays out a simplified world as a New Keynesian might see it, and a simplified world as a New Classical, John Cochrane type might see it and related each to why consumption is low and growing slowly, which lead me to comment:
This is a great, great post.
Under the PIH view, why is the nominal rate zero and the real rate negative 2 percent? The marginal product of capital is negative? Preference shifts lead to value future consumption more than the present? Bad regulation today is just a portent of worse regulation to come?
It sure *looks* like we are at the ZLB. When inflation expectations rise, short term nominal rates don't move and short term real rates become more negative.
I'd love to here how PIH/neoclassical/neo-Cochrane? view explains that.
Essentially, I'm asking how does John Cochrane's preferred model explain the zero lower bound and negative interest rates.  I've argued, before that, specifically in John's narratives the zero lower bound seems like a coincident.  For instance, he argues more expansionary monetary policy is neither like to help or hurt, which with the fed funds rate constrained at zero seems remarkably coincidental.  I was surprised by how hard he bit down on that bullet, in direct response to my comment:
It doesn't. We are at the ZLB, and the real interest rate on government bonds is negative. (Private parties borrow at higher rates, and risk premia are much more important than most macro says.)
The question is, how relevant is this fact for understanding the level of consumption. The PIH is not "the" model. As I wrote to the point of ridiculous repetition, it is a grossly oversimplified model, useful (maybe) for digesting one part of what's going on. It does not say WHY income fell, and in the big picture it alludes to, understanding the wedges in the economy's prodcutive capacity is key. 
So, at this level of abstraction, the question is, does it really matter that we are at the ZLB and real interest rates on government bonds are -2%, not the usual +1%? Is that the key most important fact and distortion causing our doldrums? Or is that a fact, an interesting, fact, but a secondary epicycle, that we don't really need for reducing the big picture down to one equation in a blog post? 
The art of economic modeling includes a lot of throwing out "realism" so you can get the important big picture. 
Does he seem annoyed?  I hope not, and not just because he could squash my future career like a bug, but because he's one of my favorite economists.

I think the key is this, "a secondary epicycle, that we don't really need for reducing the big picture down to one equation in a blog post?"  To John, the Zero Lower Bound, the negative interest rates are a side show.  There might be an interesting "epicycle" to explain it, but basically understanding the slow recovery is the same at a 4% nominal rate as a 0% nominal rate.  To me, the puzzles must be linked.  The market for risk free capital isn't clearing and conventional monetary policy is impotent.  We had a great recession, and now the recovery is incredibly slow.  My intuition suggests that those facts are central to any story that tries to understand the economy.  John thinks the ZLB is quite possibly just a distraction from what is really goin on.

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